Lufthansa surprised many in the European aviation market with its agreement to buy from SAS the remaining 20% of bmi that it did not already own. Speculation is now mounting that Lufthansa is preparing to carve up or offload bmi, with the German carrier stating it has received as many as 12 expressions of interest in the UK carrier. In this report, we speculate on who the 12 bidders may be, why they are interested, and the strategic options available to Lufthansa.

Lufthansa agreed to pay approximately GBP19 million to SAS for its stake, with a further GBP19 million to cancel a shareholder agreement relating to bmi. Lufthansa stated SAS will receive, under certain conditions, “an additional payment” (amount not disclosed) should Lufthansa decide, “on the background of its strategic analysis” to sell bmi completely or parts of the company within the next two years”. SAS, in other words, wanted to make sure it would participate in the proceeds of any on-sale.

Lufthansa made the offer to SAS having paid GBP223 million to bmi Founder, Sir Michael Bishop, earlier this year for his 50% plus one share stake in the UK carrier.

1. bmi: A medium-haul operation based at Heathrow, operating to destinations in the UK, Europe, the Middle East, Central Asia and Africa, using extensive codesharing with partners, particularly to the US (see list of destinations below), where bmi does not operate its own aircraft;

Overall, bmi group airlines operate a total of 49 aircraft, with just three A321s on order. The majority of the fleet is based around the A320 family (28 aircraft), as well as three A330s, a B757 and 17 B737 classics operated by bmibaby, according to Ascend.

In 2008, bmi generated GBP1.04 billion of revenue and reported a loss of approximately GBP100 million, which is expected to swell to GBP150-170 million this year, due to the global recession. The last set of accounts filed by bmi also record a net pension plan deficit of GBP46 million as at 31-Dec-2007. This is likely to have swollen.

Operationally, bmi has been a drag on Lufthansa. According to the latest monthly traffic results (for Aug-2009), Lufthansa’s systemwide load factor improved 1.4 ppts to 83.5%, but would have been slightly higher, at 83.7% without bmi (which reported a passenger load factor of 79.4% - year-on-year comparison not disclosed).

Lufthansa is under pressure from shareholders and credit agencies to quickly determine bmi’s future.

The rating agencies recently adjusted their ratings for Lufthansa in the face of weaker operating performance and the effects of acquisitions on its financial profile. Standard & Poor’s reduced their rating by one notch to BBB- (Outlook: negative), while Moody’s also downgraded Lufthansa by one notch to Ba1 (Outlook: stable).

Lufthansa Board Member, Stefan Lauer, told WirtschaftsWoche on 19-Sep-2009 that he “assumes there will be a solution [on the SAS stake in bmi] by the end of the year”. That the German carrier has moved so quickly on the SAS stake suggests the issue could be settled relatively quickly.

This is the most unlikely option, given the cash strain on the business and the German carrier’s lack of strategic interest in a major presence at Lufthansa, given the challenges facing Heathrow (see section below) and the German carrier’s interest in developing its existing acquisitions in Switzerland (Swiss), Belgium (Brussels Airlines) and Austria (Austrian Airlines). The agreement forged ten years ago with Sir Michael was a strategic misstep, exacerbated by the current economic downturn, and Lufthansa is likely to want to rationalise it as soon as possible. Its primary goal, of gaining rare Heathrow slots, has become less relevant today, as airlines scale back.

This is the most likely option – and could proceed quickly now that Lufthansa has moved to 100% ownership of bmi. Lufthansa will seek to develop some competitive tension, possibly establishing auction-style processes for the various bmi components.

Heathrow slots not as valuable as they were: Why a bmi break-up is likely

In Mar-2008, Continental Airlines paid what was thought to be a record USD105 million (then USD209 million) for four sets of prime slots at Heathrow, or GBP26.25 million per pair.

bmi valued its slot portfolio at the start of 2008 at GBP770 million – or GBP1.54 million per pair. But as the recent Lufthansa deal to takeover Sir Michael’s stake valued the UK carrier at just over GBP600 million, the value of those slots has plummeted as a result of the global economic downturn and the severe downturn in premium business.

As such, a quick sale by Lufthansa of bmi, if it were to occur, would reflect the German carrier’s strategic objectives in continental Europe, but could also be interpreted as a vote of no-confidence in the outlook for demand at Heathrow, reflecting:

(1) Weak premium demand outlook. Continued retrenchment and rationalisation of activity in the financial sector has led to questions from airlines including British Airways and Virgin Atlantic that premium demand levels could be depressed for some time;

(3) Environmental/taxation concerns, as the UK’s Air Passenger Duty increases and emission trading costs increase for the airline sector;

(4) The EU-US open skies era. Lufthansa may also take the view that the longer term influence of the EU-US open skies agreement may see more point-to-point traffic between the two regions, thus diluting London Heathrow’s hub role. The UK regional market, for example, has been transformed by LCC operators who fly direct and at lower cost to destinations across Europe.

The 12 likely suitors

Up to 12 companies have reportedly expressed interest in Lufthansa’s stake in bmi, including carriers based in Europe, North America and the Middle East. Before reviewing the list, it is important to first consider the global airline alliance situation at Heathrow, as it will drive much of the bidding.

oneworld has its dominant position to protect, while Star and SkyTeam (in particular) have shown interest in the past in growing their presence at Heathrow. Balancing this, certain non-aligned carriers, including Virgin Atlantic and Emirates are keen to ensure the alliance stranglehold does not intensify, particularly at key markets such as Heathrow.

CEO, Steve Ridgway, stated in Oct-2008 that a tie up with bmi would be a "very compelling opportunity" to make his airline a stronger competitor to BA at Heathrow. Sir Richard Branson’s Virgin Group has recently recapitalised Virgin America and Australia’s Virgin Blue and, on this form, may be prepared to underwrite a push for the medium-haul part of bmi, to provide feed into Virgin Atlantic’s long-haul operation. Singapore Airlines (SIA), which owns 49% of Virgin Atlantic, has been seeking to offload its stake in the carrier for over a year. SIA is unlikely to be supportive.

CEO, Willie Walsh, stated in May-2009 that bmi’s slots at Heathrow are “too tempting to ignore”, despite BA’s weak financial position and ongoing merger discussions with Iberia. Mr Walsh told the Financial Times, “in the current environment, it is difficult to argue we should go out and acquire those slots, but having said that, it may be the only opportunity we ever get." BA recently raised over GBP600 million in fresh capital and has stated its mid-year “emergency” situation has passed. EU completion regulators may however be reluctant to allow BA to obtain any more Heathrow slots without significant remedies, including making slots available for rival carriers.

Flybe is interested in acquiring “parts” of bmi and has officially confirmed its interest to Lufthansa. Chairman and CEO, Jim French, stated Flybe was an "acquisitive airline", but also a “very low risk company” and “very detailed due diligence” would be conducted. Flybe, recently acquired BA Connect domestic services from BA, which owns 15% of Flybe. A joint bid for bmi has been ruled out.

Delta recently closed USD2.1 billion of financing transactions, marking a significant step in further strengthening its liquidity position. It ended Sep-2009 with around USD5.6 billion in available cash, which could be used for potential investments in Japan Airlines and bmi, to further entrench its global ambitions. For cashed-up buyers, there are unique potential bargains to be had.

Air France-KLM has a trans-Atlantic JV with Delta that it is keen to develop. The acquisition of additional slots at Heathrow would further this development, after tentative initial steps at the London hub last Summer. A joint bid with Delta is possible.

Emirates controls the largest amount of slots at Heathrow of the Middle East carriers (0.7%) and has been a vehement opponent to the market power exerted by the global airline alliances. The airline is not acquisitive by nature (its SriLankan Airlines stake is now for sale), nor is it flush with funds, but Heathrow could suit its development objectives, which involve a future fleet of 58 A380s – an aircraft highly suited to slot constrained airports.

Etihad Airways is part of the Abu Dhabi Government’s ambitious push into the global aviation market and a bid by this well capitalised airline is not beyond the realms of possibility. It will be interesting to see if any of the major Middle East carriers have any traction in discussions to obtain slots from Lufthansa at Heathrow, as they offer a significant competitive threat to the German carrier.

Ryanair has previously threatened to bid for Lufthansa, so making an offer for bmi (which offers very little opportunity for the LCC – see section below on who won’t be bidding) will be a PR opportunity Michael O’Leary will not want to miss. O’Leary’s modus operandi, as demonstrated by its past bids for Aer Lingus, is to “distract and conquer”.

12. ???

Who WON’T be bidding?

LCCs, including easyJet are not expected to bid for part or all of bmi, despite a push by many into key business markets. Heathrow’s short-haul traffic is mostly connecting to medium- and long-haul flights and has exhibited some growth, while Heathrow’s point-to-point traffic for UK domestic business has seen no growth in a decade.

Airlines at Heathrow generally allocate their more precious peak time slots to serve two-sector passengers. The LCCs, including easyJet, have captured most of the growth from the other London airports and are content operating from these airports. Just one LCC, Blue1 operates from Heathrow, twice a day.

easyJet’s model offers no connectivity, making the carrier an unlikely bmi bidder, while the very high landing charges at Heathrow are a definite turn-off. easyJet would also have little leverage of volume to get the costs down. Heathrow’s heavy congestion would lower aircraft utilisation and effect on-time performance across their network.

And the winners gain…

An opportunity for an 11.5% slice of the world’s busiest international airport is a very rare one – and it could be gone by the end of 2009.

The airline industry is under considerable financial strain at present, but many of the larger airlines have been successful in raising additional finance to help them through the cold winter ahead, and to entertain one-off market opportunities, such as bmi.

For Lufthansa, the sale process is complex: it will want to maximise any sale price, but at the same time will not want to help SkyTeam establish a powerful hub at Heathrow, which could come back to hurt it and the Star partners in a couple of years.

Similarly, while bmi is making heavy losses (and, whatever happens, must be scaled back), it does offer Lufthansa a negotiating tool for establishing new partner relationships. One advantage with a more complicated partnership arrangement would be that Lufthansa may then be able to avoid a transparent paper loss of several hundred million euros - which would occur in the event of a straightforward sale.

On one side of the world, Japan Airlines' woes could lead to a reshaping of regional markets and a rebalancing of the global alliances. Meanwhile, in Europe, Lufthansa's preparations to sell down its reluctant ownership of bmi could provoke significant changes in market power and airline partnerships. Each of these one-off events is a child of the economic downturn. They offer unique opportunities for market access and expansion and each is ridden with political, operational and strategic complexity.

Want More Analysis Like This?

CAPA Membership provides access to all news and analysis on the site, along with access to many areas of our comprehensive databases and toolsets.